Dow theory was formulated from a series of Wall Street

Journal editorials authored by Charles H. Dow from

1900 until the time of his death in 1902.

These editorials reflected Dow’s beliefs on how the stock

market behaved and how the market could be used to
measure the health of the business environment.
Due to his death, Dow never published his complete
theory on the markets, but several followers and
associates have published works that have expanded on
the editorials.

Some of the most important contributions to Dow theory

were William P. Hamilton's "The Stock Market
Barometer" (1922), Robert Rhea's "The Dow Theory"
(1932), E. George Schaefer's "How I Helped More Than
10,000 Investors To Profit In Stocks" (1960) and
Richard Russell's
Dow first used his theory to create the Dow Jones
Industrial Index and the Dow Jones Rail Index (now
Transportation Index), which were originally compiled
by Dow for The Wall Street Journal.

Dow created these indexes because he felt they were an

accurate reflection of the business conditions within the
economy because they covered two major economic
segments: industrial and rail (transportation).

While these indexes have changed over the last 100

years, the theory still applies to current market indexes.
The first basic premise of Dow theory suggests that all
information - past, current and even future - is
discounted into the markets and reflected in the prices of
stocks and indexes.

That information includes everything from the emotions

of investors to inflation and interest-rate data, along with
pending earnings announcements to be made by
companies after the close.
Based on this tenet, the only information excluded is that
which is unknowable, such as a massive earthquake.

But even then the risks of such an event are priced into
the market.

Like mainstream technical analysis, Dow theory is

mainly focused on price.

However, the two differ in that Dow theory is concerned

with the movements of the broad markets, rather than
specific securities.
It's important to note that while Dow theory itself is
focused on price movements and index trends,
implementation can also incorporate elements of
fundamental analysis, including value- and fundamental-
oriented strategies.

Having said that, Dow theory is much more suited to

technical analysis.
To do this, the theory uses trend analysis.

An important part of Dow theory is distinguishing the

overall direction of the market.

Before we can get into the specifics of Dow theory trend

analysis, we need to understand trends.

First, it's important to note that while the market tends to

move in a general direction, or trend, it doesn't do so in a
straight line.
The market will rally up to a high (peak) and then sell off
to a low (trough), but will generally move in one
direction.

Dow theory identifies three trends within the market:

primary, secondary and minor.

A primary trend is the largest trend lasting for more then

a year, while a secondary trend is an intermediate trend
that lasts three weeks to three months and is often
associated with a movement against the primary trend.

Finally, the minor trend often lasts less than three weeks
and is associated with the movements in the intermediate
trend.
In Dow theory, the primary trend is the major trend of
the market, which makes it the most important one to
determine.
The primary trend will also impact the secondary and
minor trends within the market.
The primary trend will also impact the secondary and
minor trends within the market.

Dow determined that a primary trend will generally last

between one and three years but could vary in some
instances.

For example, if in an uptrend the price closes below the

low of a previously established trough, it could be a sign
that the market is headed lower, and not higher.

Regardless of trend length, the primary trend remains in

effect until there is a confirmed reversal.
In Dow theory, a primary trend is the main direction in
which the market is moving.

Conversely, a secondary trend moves in the opposite

direction of the primary trend, or as a correction to the
primary trend.

For example, an upward primary trend will be composed

of secondary downward trends.
This is the movement from a consecutively higher high
to a consecutively lower high. In a primary downward
trend the secondary trend will be an upward move, or a
rally.

This is the movement from a consecutively lower low to

a consecutively higher low.

Below is an illustration of a secondary trend within a

primary uptrend.
Notice how the short-term highs (shown by the
horizontal lines) fail to create successively higher peaks,
suggesting that a short-term downtrend is present.

Since the retracement does not fall below the October

low, traders would use this to confirm the validity of the
correction within a primary uptrend.

In general, a secondary, or intermediate, trend typically

lasts between three weeks and three months, while the
retracement of the secondary trend generally ranges
between one-third to two-thirds of the primary trend's
movement.
For example, if the primary upward trend moved the
DJIA from 10,000 to 12,500 (2,500 points), the
secondary trend would be expected to send the DJIA
down at least 833 points (one-third of 2,500).

Another important characteristic of a secondary trend is

that its moves are often more volatile than those of the
primary move.
The last of the three trend types in Dow theory is the
minor trend, which is defined as a market movement
lasting less than three weeks.
The minor trend is generally the corrective moves within
a secondary move, or those moves that go against the
direction of the secondary trend.

Due to its short-term nature and the longer-term focus of

Dow theory, the minor trend is not of major concern to
Dow theory followers.

But this doesn't mean it is completely irrelevant; the

minor trend is watched with the large picture in mind, as
these short-term price movements are a part of both the
primary and secondary trends.
Most proponents of Dow theory focus their attention on
the primary and secondary trends, as minor trends tend
to include a considerable amount of noise.

If too much focus is placed on minor trends, it can to

lead to irrational trading, as traders get distracted by
short-term volatility and lose sight of the bigger

Stated simply, the greater the time period a trend

comprises, the more important the trend.
Since the most vital trend to understand is the primary
trend, this leads into the third tenet of Dow theory, which
states that there are three phases to every primary trend –
the accumulation phase (distribution phase), the public
participation phase and a panic phase (excess phase).

Let us now take a look at each of the three phases as they

apply to both bull and bear markets.
The first stage of a bull market is referred to as the
accumulation phase, which is the start of the upward
trend.

This is also considered the point at which informed

investors start to enter the market.
The accumulation phase typically comes at the end of a
downtrend, when everything is seemingly at its worst.

But this is also the time when the price of the market is
at its most attractive level because by this point most of
the bad news is priced into the market, thereby limiting
downside risk and offering attractive valuations.

However, the accumulation phase can be the most

difficult one to spot because it comes at the end of a
downward move, which could be nothing more than a
secondary move in a primary downward trend - instead
of being the start of a new uptrend.
This phase will also be characterized by persistent
market pessimism, with many investors thinking things
will only get worse.
From a more technical standpoint, the start of the
accumulation phase will be marked by a period of price
consolidation in the market.

This occurs when the downtrend starts to flatten out, as

selling pressure starts to dissipate.

The mid-to-latter stages of the accumulation phase will

see the price of the market start to move higher.

A new upward trend will be confirmed when the market

doesn't move to a consecutively lower low and high.
When informed investors entered the market during the
accumulation phase, they did so with the assumption that
the worst was over and a recovery lay ahead.

As this starts to materialize, the new primary trend

moves into what is known as the public participation
phase.
During this phase, negative sentiment starts to dissipate
as business conditions - marked by earnings growth and
strong economic data - improve.

As the good news starts to permeate the market, more

and more investors move back in, sending prices higher.

This phase tends not only to be the longest lasting, but

also the one with the largest price movement.
It's also the phase in which most technical and trend
traders start to take long positions, as the new upward
primary trend has confirmed itself - a sign these
participants have waited for.
As the market has made a strong move higher on the
improved business conditions and buying by market
participants to move starts to age, we begin to move into
the excess phase.

At this point, the market is hot again for all investors.

The last stage in the upward trend, the excess phase, is
the one in which the smart money starts to scale back its
positions, selling them off to those now entering the
market.
At this point, the market is marked by, as Alan
Greenspan might say, "irrational exuberance".

The perception is that everything is running great and

that only good things lie ahead.

This is also usually the time when the last of the buyers
start to enter the market - after large gains have been
achieved.
Like lambs to the slaughter, the late entrants hope that
recent returns will continue.

Unfortunately for them, they are buying near the top.

During this phase, a lot of attention should be placed on
signs of weakness in the trend, such as strengthening
downward moves.

Also, if the upward moves start to show weakness, it

could be another sign that the trend may be near the start
of a primary downtrend.
The first phase in a bear market is known as the
distribution phase, the period in which informed buyers
sell (distribute) their positions.

This is the opposite of the accumulation phase during a

bull market in that the informed buyers are now selling
into an overbought market instead of buying in an
oversold market.
In this phase, overall sentiment continues to be
optimistic, with expectations of higher market levels.

It is also the phase in which there is continued buying by

the last of the investors in the market, especially those
who missed the big move but are hoping for a similar
one in the near future.
This phase is similar to the public participation phase
found in a primary upward trend in that it lasts the
longest and will represent the largest part of the move -
in this case downward.

During this phase it is clear that the business conditions

in the market are getting worse and the sentiment is
becoming more negative as time goes on.
The market continues to discount the worsening
conditions as selling increases and buying dries up.
The last phase of the primary downward market tends to
be filled with market panic and can lead to very large
sell-offs in a very short period of time.

In the panic phase, the market is wrought up with

negative sentiment, including weak outlooks on
companies, the economy and the overall market.
During this phase you will see many investors selling off
their stakes in panic.

Usually these participants are the ones that just entered

the market during the excess phase of the previous run-
up in share price.

But just when things start to look their worst is when the
accumulation phase of a primary upward trend will begin
and the cycle repeats itself.
So far, we have discussed a lot of the ideas behind Dow
theory along with its main tenets. In this section, we'll
take a look at the technical approach behind Dow theory,
such as how to identify trend reversals.
Charles Dow relied solely on closing prices and was not
concerned about the intraday movements of the index.

For a trend signal to be formed, the closing price has to

signal the trend, not an intraday price movement.
Another feature in Dow theory is the idea of line ranges,
also referred to as trading ranges in other areas of
technical analysis.

These periods of sideways (or horizontal) price

movements are seen as a period of consolidation, and
traders should wait for the price movement to break the
trend line before coming to a conclusion on which way
the market is headed.

For example, if the price were to move above the line, it's
likely that the market will trend up.
One difficult aspect of implementing Dow theory is the
accurate identification of trend reversals.

Remember, a follower of Dow theory trades with the

overall direction of the market, so it is vital that he or she
identifies the points at which this direction shifts.

One of the main techniques used to identify trend

reversals in Dow theory is peak-and-trough analysis.
A peak is defined as the highest price of a market
movement, while a trough is seen as lowest price of a
market movement.

Note that Dow theory assumes that the market doesn’t

move in a straight line but from highs (peaks) to lows
(troughs), with the overall moves of the market trending
in a direction.
An upward trend in Dow theory is a series of
successively higher peaks and higher troughs.

A downward trend is a series of successively lower

peaks and lower troughs.
The sixth tenet of Dow theory contends that a trend
remains in effect until there is a clear sign that the trend
has reversed.

Much like Newton's first law of motion, an object in

motion tends to move in a single direction until a force
disrupts that movement.
Similarly, the market will continue to move in a primary
direction until a force, such as a change in business
conditions, is strong enough to change the direction of
this primary move.
A reversal in the primary trend is signalled when the
market is unable to create another successive peak and
trough in the direction of the primary trend.

For an uptrend, a reversal would be signalled by an

inability to reach a new high followed by the inability to
reach a higher low.
In this situation, the market has gone from a period of
successively higher highs and lows to successively lower
highs and lows, which are the components of a
downward primary trend.
The reversal of a downward primary trend occurs when
the market no longer falls to lower lows and highs.

This happens when the market establishes a peak that is

higher than the previous peak followed by a trough that
is higher than the previous trough, which are the
components of an upward trend.
Dow theory represents the beginning of technical
analysis. Understanding this theory should lead you to a
better understanding of technical analysis and of an
analyst's view of how markets work.
•Dow theory was formulated from a series of Wall Street
Journal editorials authored by Charles H. Dow, which
reflected Dow’s beliefs on how the stock market behaved
and how the market could be used to measure the health
of the business environment.
•Dow believed that the stock market as a whole was a
reliable measure of overall business conditions within
the economy and that by analyzing the overall market,
one could accurately gauge those conditions and identify
the direction of major market trends and the likely
direction of individual stocks.
•The market discounts everything.

•Dow theory uses trend analysis to determine which way

the market is headed.

•Primary trends are major market trends.

•Secondary trends are corrections of the primary trend.

•Market indexes must confirm each other. In other

words, a major reversal from a bull or bear market
cannot be signalled unless both indexes (generally the
Dow Industrial and Rail Averages) are in agreement.
•Market indexes must confirm each other. In other
words, a major reversal from a bull or bear market
cannot be signalled unless both indexes (generally the
Dow Industrial and Rail Averages) are in agreement.

•Volume must confirm the trend. The indexes are the

main signals that indicate a security's movement, but
volume is used as a secondary indicator to help confirm
what the price movement is suggesting.
•A trend will remain in effect until a clear reversal
occurs.
•Dow relied solely on closing prices for determining
trends, not intraday price movements.
•Peak-and-trough analysis is a key technique used to
identify trends in Dow theory.

•Since the advent of Dow theory, more advanced

techniques and tools have expanded on this theory and
begun to take its place.

•One problem with Dow theory is that followers can

miss out on large gains due to the conservative nature of
a trend-reversal signal.

•Another problem with Dow theory is that over time, the

economy - and the indexes originally used by Dow - has
changed.